4 Undervalued Small-Value Stocks to Buy

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Every Monday morning I sit down with Morningstar’s U.S. market strategist Dave Sekera to discuss one thing that’s on his radar this week, one new piece of Morningstar research, and a few stock picks or pans for the week ahead.

Dave, it looks like there’s a lot on your radar this week. First, of course, you’ll be watching the banks. Now, last week, bank stocks took a hit and they’re getting kind of hammered this morning, too, after Silicon Valley Bank’s SIVB liquidity problems. And then over the weekend, regulators shut down Signature Bank SBNY. Explain what happened.

Dave Sekera: Good morning, Susan. Really, what I think happened here, it’s just a classic run on the bank once depositors started to have some questions regarding these banks’ solvency. I think we actually need to dig a little bit into the situation and the characteristics here to really understand not only just what happened here, but whether or not we think this could then end up being a problem for other banks and for the market in general.

At Silicon Valley Bank, their deposit base doubled in 2021, and those demand deposits constituted the bulk of their funding. However, the bank had very little long-term debt in place, and I think that’s really part of the genesis of the problem here. So, as they got all of those deposits in, Silicon Valley Bank invested much of those in long-duration mortgage-backed securities in 2022. And, of course, you have to remember interest rates were much lower back then. So essentially, in my mind, I think what they were doing is they were borrowing short and lending long.

So, what caused the problem, and I guess we’re getting into the weeds here, but banks can hold assets or designate them as investments in two different ways. One, you have available for sale, and available for sale means that you actually have to mark those assets to market every quarter, or you have what’s called a hold-to-maturity account. And in that account, because you assume that you’re going to hold these all the way to maturity, you don’t have to mark them to market but you keep them on your books at the price that you bought that security.

Then as interest rates rose in the latter half of 2022, the value of those hold-to-maturity account securities did begin to lose value, and in some cases very significantly. So, management decided that they needed to sell some of those securities and wanted to reinvest those in higher-yielding securities. But to do so, they needed to raise capital in order to be able to get their capital levels back up to offset those losses. So, when depositors saw that they were looking to raise that capital, they became nervous about the bank’s solvency and began to transfer some of their deposits out of that bank.

Well then, that started kind of a negative reinforcing circle here, that then as that happened, that forced management then to sell more of those hold-to-maturity securities at a loss, which then caused them to have even lower capital levels and concerned depositors even more, so then more depositors started to pull their money out of the bank, and finally, just too many depositors all tried removing their money from the bank too quickly and the bank then had to close as it couldn’t fund all of those outflows.

Dziubinski: As of Monday morning, the FDIC has stepped in for both banks and their depositors. But as we said earlier, bank stocks are down premarket. So what is exactly going on at this point?

Sekera: The FDIC did step in, and they are announcing that they’re going to make depositors whole, even those depositors over the insurance limit. And what the FDIC is trying to do is stop any potential contagion, any potential for this to start leading to other runs on other banks and keep that from occurring, keep that even from when it starts.

I think what the market is still nervous about this morning is that there are many other banks that do have losses in those hold-to-maturity accounts. And I think the market at this point really needs to have enough time to identify any other banks that they think there could be solvency issues, look for banks that have a similar sort of characteristics, and readjust their valuations on those names.

Now, I do think it’s going to be held mostly to smaller and regional banks. The large banks, they’ve got plenty of liquidity, they’ve got lots of different ways of being able to raise cash to fund deposit outflow. So, I’m not worried about the larger banks. And I think once the market becomes more confident that the vast majority of banks don’t really have the same set of characteristics, I do think that market volatility will start coming back down to normal over the next couple days.

Dziubinski: What does Morningstar expect at this point? Do we expect other banks to face similar liquidity problems?

Sekera: That is certainly the question that’s on everybody’s mind right now. But for the most part, I do think that this is going to be contained to the smaller and the regional banks that could have a similar set of characteristics. Those characteristics being specifically where they don’t have enough long-term debt on the balance sheet and rely too much on short-term funding. And then those banks whose assets are very narrowly focused. If you think about Silicon Valley Bank, their assets were very narrowly focused in a lot of venture capital companies. And specifically, those type of assets weren’t eligible to be pledged as collateral, so they weren’t able to use them to raise cash.

Now, we did review the banks under our coverage, and for the most part our coverage is skewed to larger and more high-quality-type banks. But there are certainly smaller and regional banks out there that do have these large unrealized losses in their hold-to-maturity accounts. But for the most part, it doesn’t appear that it’s going to result in the same reduction of capital levels as we saw at Silicon Valley Bank. And the other thing about these banks is that they will have other types of loans and assets that they can pledge for collateral in order to raise cash to be able to pay deposits when people demand those deposits back.

Now, having said all that, the banking business is all about confidence. And once that confidence is lost, we certainly could see a few other smaller or regional banks fail here in the short term. But in my mind, this is not a systemic issue for the larger banking sector.

Dziubinski: Let’s pivot a little bit and talk about something else on your radar this week, and that’s the CPI number for February. What are the market’s expectations there and what impact do you think that’s going to have on the stock market this week?

Sekera: Well, with everything going on, I think the CPI print, it’s certainly going to take on even heightened importance this week when we’re thinking about what the Fed’s next move is going to do. So at this point, I do think it’s the last major inflationary metric that we have released before the Fed meeting, which is the 21st and 22nd.

In thinking about what we’ve seen most recently, we did see the payrolls number come out much higher than expected. That may cause the Fed to become more concerned that the market for employment is still too hot and might result in wage inflation. So, I do think the Fed is still definitely concerned about inflation, even though we do have some of the risk in the banking sector that we see.

Now, if CPI is hotter than expected, I would expect to see stocks decline. I think then the market will price in, then a higher probability that the Fed could keep monetary policy higher for longer, which also then has a higher probability of causing more deeper and longer recession. If CPI comes in in line, I would actually expect probably a slight relief rally that the number wasn’t worse. And if the number is better than expected, then I would certainly expect to see the stocks rally just with the thought that the Fed doesn’t have to fight inflation as much and keep rates as high for as long.

Dziubinski: Against today’s backdrop, Dave, what are the expectations now as far as the next Fed meeting at the end of this month? Is the expectation at this point an interest-rate increase of 25 basis points?

Sekera: It is. I took a quick look at the fed-fund futures this morning, and we’re still seeing a very, very high probability that the Fed will hike by 25 basis points at the March meeting. Although there is really, at least according to the market right now, no chance of a 50-basis-point hike. I think that’s off the table for this next meeting, and I think it’s off the table for good, in my own mind.

But again, thinking about what’s going on out there, I do think that the Fed definitely, while it’s still going to be very data dependent, also wants to make sure that they’re not causing any kind of policy ire by bringing interest rates up too high. We have certainly seen interest rates go up further and faster than what we’ve seen since the ‘80s.

So at this point, I do think the Fed is getting very close to the point where they’re going to want to pause, kind of see how that really plays through the real economy over the next couple of months before they decide to make any moves thereafter.

Dziubinski: Well, let’s move on to some new research from Morningstar, talk a little bit about your latest market outlook, which viewers can find on morningstar.com. In the outlook, you say that small-value stocks look attractive. Let’s first talk a little bit about how small-value stocks as a group have performed over the past year or so and what’s been driving that performance.

Sekera: You have to remember the value category did hold up the best during the broad market selloff last year in 2022. And when I look at the breakdown, small-cap value only fell 6.6% last year. And that compares to small core, which fell 14%, and small growth, which really got hammered and was down 33% last year.

We have seen the small-growth category rebound. I mean, I think it’s really just coming off of those oversold levels at the end of last year. I think it’s up about 4% year to date, whereas small core is up about 3%. Again, the core category did sell off last year as well, whereas small value’s actually kind of struggling this year. Small value is actually down about 1%. And I think a lot of that is just due to the rebound that we’ve seen in those other two categories have been more for technical reasons than necessarily fundamental reasons.

Dziubinski: Let’s talk a little bit about valuations, comparing small-cap value stocks today relative to say, larger-cap stocks and to growth stocks.

Sekera: Sure. When we break down into the different categories, small caps right now are trading at about a 25% discount to fair value, whereas large-cap stocks and mid-cap stocks are both trading in line with the broad market, probably in that 10% to 12% discount area. And then looking by different type of categories, growth stocks are trading at a 16% discount at this point.

And then within the small-cap category, taking a look at the different valuations there, value in small cap is actually about a 40% discount to fair value, whereas core and growth are closer to fair value at 14% and 16% discounts, respectively.

Dziubinski: Let’s move on to the picks portion of our program. This week, we’re talking about several small-value stocks you like. Your first pick is Lyft LYFT. What do you like about it?

Sekera: Lyft is currently rated 5 stars and trades at a whopping 70% discount to our long-term intrinsic valuation for that company. And the company does actually have a narrow economic moat assigned to it.

What I really like about Lyft is I think it’s a great play on consumer normalization at this point. And just thinking about consumer behavior, as we see the pandemic getting further and further in the rearview mirror, we’re definitely seeing more people going out. And so for a company like Lyft, that’s going to benefit as they see an increase both in the number of riders and the number of rides per rider.

Dziubinski: And your second small-value pick is Sabre SABR. Is this a play on the rebound in travel, Dave?

Sekera: It is but specifically on business travel. So Sabre’s also a 5-star-rated stock trading at about a 60% discount to our fair value, also rated with a narrow economic moat.

So, what we’ve seen in travel is that leisure travel, for the most part, has already recovered to prepandemic levels, but business travel has lagged behind, and we expect to see that starting to catch up this year. And based on Sabre’s products, we do think it’s one of the better-positioned companies to be able to capture on that rebound for business travel.

Dziubinski: Now, your next pick is an energy stock, which I wouldn’t necessarily expect to see after the runup in energy last year. The pick is Equitrans Midstream ETRN. What’s the story here?

Sekera: So it’s a 5-star-rated stock and it trades at about a 45% discount to fair value. And as you mentioned, it’s really one of the very few undervalued stocks that we still see in the energy sector. And for those people that are looking for high-dividend yields, this one certainly is it. It pays about a 10% dividend yield at this point.

And I think what’s going on here, what the real story is, is that there’s been a lot of concern about the viability of one of its projects, specifically the Mountain Valley Pipeline. But at this point, according to our analysis, we think the market’s already actually assigning a zero value to that pipeline. And so we think that actually helps limit further downside in that stock in our view.

Dziubinski: And then your last pick this week is Scotts Miracle Gro SMG. Why do you like it?

Sekera: Sure. Scotts is a 4-star-rated stock, trades at a 36% discount, also with a narrow economic moat. And this is one where you have to look at what’s happened with that company and with its stock over the past couple of years due to the pandemic.

So in 2020, we saw a large surge in gardening and people were staying at home and that prompted more interest in landscaping. So Scotts did very well during that time period. And then in 2022, I think we start seeing sales decline. And that’s really just because that pandemic-related growth started falling behind that company on a year-over-year basis.

Looking forward, we are starting to see kind of a resumption in demand, specifically in the Southern U.S. markets as we’ve seen favorable weather there help drive an early start to this year’s gardening activity. And thinking through this company, we do forecast mid-single-digit growth here in 2023. So, I do think this is one that’s set up to look pretty good for the next year.

Dziubinski: Well, thanks for your time this morning, Dave. Be sure to join us again live on YouTube next Monday at 9 a.m. Eastern, 8 a.m. Central. And while you’re at it, subscribe to Morningstar’s channel. Have a great week.